How are we to end Obama’s Great Recession? Keynesian economic theory has completely failed to do the job.

A dialogue with a reader who generally defends the Keynesian thesis:

Reader:

If you maintain that during a recession that it is best to reduce spending by all parties, how does that get the economic engine going again? Austerity during a depression is obviously non-nonsensical.

The only way a factory owner is going to hire more staff or build new plant and facilities, is if demand for his product increases.

The only way for demand for his product to increase is for more customers to have enough money in their pockets to buy!

This simple relationship between supply and demand is taught in Economics 101 in every college in the country (and not just in those “progressive liberal commie colleges” on the East and West coasts).

My reply:

The difference in our views centers in what I believe to be your faith that only government spending can produce an increase in consumer spending. For the entire history of the North American colonies and the United States until the administration of Herbert Hoover there was never such intervention in the economy.

Yet during that period the United States grew to become the greatest economic power on earth, despite enduring numerous punishing recessions.

The last recession in which there was no government intervention – that of 1920 – 21 – experienced more severe conditions than have beset us in this recession. Government spending, however, was cut markedly and the government reduced the national debt. Business rebounded quickly and sharply.

The root difference in our opposed views has to do with the cause of recessions. The Keynesian hypothesis, which I believe is yours, is that recessions are caused by too much savings and too little consumption. Hence the prescription to flood the economy with deficit spending financed by manufacturing fiat money.

In the months before the 2007-08 collapse of the financial industry, Fed chairman Ben Bernanke made numerous speeches in which he attributed gathering signs of economic distress to what he called a “worldwide glut of savings.” In retrospect this is revealed as one of the most colossal misapprehensions in economic history. The real world, we learned in short order, was swamped by excessive debt.

The earlier view, especially as expounded by the Austrian school of economics, is that central banks’ creation of excessive fiat money during strong economic times gives false signals to business, leading to over-expansion of capacity, especially in the basic industry sectors. That is what occurred under the newly created Federal Reserve system between 1924 and 1928, as well as during the years preceding our 1970s’ stagflation, the dot.com boom, and the current recession.

Consumers are encouraged by the flood of phony money to go into debt beyond their capacities to repay it. In the current mess, mortgage debt was far in excess of the creditworthiness of home buyers; most of the explosion of imports from China was financed by home equity loans; and everybody seemed to have at least two credit cards maxed out.

The Fed increased the money supply far more rapidly than the economy was growing in the 1920s; ditto in the 1960s before our devastating bout with stagflation, during the Clinton administration before the dot.com boom and bust, and during the four or five years before our current disaster. This illusion of prosperity fed the fires of inflation at the same time that consumer savings, as a percentage of income, were declining. Just before our 2007-08 collapse, the savings rate went negative; we were spending more than we were making.

When the financial storm overwhelmed us, we had a huge oversupply of consumer capital goods in the housing industry, far too much money invested speculatively in land for additional home building, and excess capacity in all the industries supplying the housing market. Consumers were tapped out with debt, and businesses suddenly could no longer repay all their debt to banks and bond holders.

Every recession in our history has had similar conditions of over expansion on debt.

The only way to get out of recessions is to lay off unneeded workers, cut other costs, and liquidate excess capacity or allow uneconomic businesses to go bankrupt. During that time, businesses and consumers must resume saving and paying down their debts. Only then will the economy regain sound footing and be able to support rehiring of workers and expansion of output.

Government’s failing to step aside and allow businesses and individuals to work out their situations only prolongs the process and makes it far more punishing to everyone. Government’s so-called stimulus spending is analogous to increasing the narcotic dosage for a patient who has just overdosed and is near death.

Because Obama has fostered anti-business regulations and repeatedly tinkered with one-shot spending such as cash-for-clunkers or “stimulus” programs aimed at bolstering labor unions, the economy continues to limp along, each year at a lower rate of increase than before.

Business’s limited expansion has been primarily in overseas markets or for export. Increases in business earnings have come, not from increased sales, but mostly from cost-cutting, including outsourcing to countries without rapacious labor unions that drive up costs or refuse to permit essential cost reductions (cf. Hostess/Twinkees).

Since Obama’s accession in 2009, he has lambasted businesses as the cause of the recession. In reality the Federal Reserve is the author of our troubles through its monetary support of the Keynesian doctrine that government’s increased deficit spending is the answer to every economic problem. Reduced savings and mounting debt is Keynes’s theoretical road to prosperity.

The only beneficiary of the Fed’s easy money policy has been the stock market. The Dow Jones and other market indexes have expanded into bubble territory while brokers cheer every new announcement of fiat money creation by Fed chairman Bernanke. Meanwhile, the real unemployment level, including people who have given up looking for jobs, continues to rise every quarter.

Ultimately business will muddle through the mess that Obama has created, but it has been and will be at a far more painful and slower pace than if the Democrat/Socialist Party had not pursued its interventions and its class warfare aimed at socialistic redistribution of income.

[Editors note: This posting originally appeared in the View From 1776 blog.]

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